25 tax tips for RIA M&A deals and other small business sales

November 24, 2023 11:00 AM

The price tags of hundreds of M&A deals for registered investment advisory firms draw most of the attention each year, but the tax implications reverberate for far longer.

Through interviews with five experts in RIA M&A transactions and combing through the available research about deals involving any small businesses, Financial Planning compiled the following 25 tax tips. The key concerns for buyers and sellers include entity structure, the allocations in a given transaction, planning strategies such as charitable gifts and an array of other potential tax factors to consider around any RIA M&A deal.

FP interviewed the following five experts to help assemble the below guidance for financial advisors seeking to sell their RIA or other small business owners pursuing a transaction:

Stan Gregor, CEO of Parsippany, New Jersey-based registered investment advisory firm Summit Financial

Gary Roth, co-founder and co-CEO of Lenexa, Kansas-based RIA firm Modern Wealth Management

Christopher Toumajian, chief financial officer of Torrance, California-based RIA firm EP Wealth Advisors

Paul Lawler, general counsel of Palm Beach, Florida-based private RIA investor firm Wealth Partners Capital Group

John Furey, managing partner of consulting and transaction advisory firm Advisor Growth Strategies

Scroll down the slideshow for 25 tax tips for RIA buyers and sellers in M&A deals.
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One of many factors

For those "thinking about the tax side if you've never done a deal before," Lawler said to keep in mind that taxes represent only one factor out of many involved with a deal. For example, he noted that the buyer in an asset purchase assumes none of the liabilities from the seller.

"There's a whole lot less risk associated with the transaction when it's structured as an asset purchase," Lawler said. "The tax component is an important piece, but it's certainly not the only piece."

M&A deals are complex

Advisors selling their businesses will want to drop any expectation that the process will be simple, according to Toumajian.

"These are complicated — for most sellers, this is the only time that they're selling their business," Toumajian said. "Starting those conversations as early as possible and just getting educated on it is really key. These are not straightforward. There are a lot of variables."

Hire a tax pro

Sellers of RIAs or other small businesses should seek professional advice outside of the potential buyer's team, Roth said in an email.

"First and most fundamental, unless you want a surprise tax bill, get tax advice before you get too far into the sale negotiations," he said. "Different sellers have different priorities, so make sure you understand your own situation and what the ramifications of your sale will be.

"We have seen many sellers over the years ask the buyer how the sale will be treated from a tax standpoint. However, the buyer cannot give you tax advice, and their own prerogatives may be different than yours. Just like with financial advice, you need to consult a tax advisor when selling."

Three main issues to keep in mind

RIA sellers should think through the tax and estate ramifications carefully before agreeing to the deal, Gregor said in an email.

"When selling an RIA, it is important to consider the tax implications of the sale, while also considering the long-term growth trajectory of the practice," Gregor said. "Structuring a deal to receive capital gain treatment, as opposed to ordinary income, is generally advantageous to the seller. In other words, the seller should consider the after-tax proceeds the sale will generate.

"The seller should also consider how their practice will operate after the transaction. If the seller wishes to continue working with their clients, it is important to retain participation in the growth of the business in a tax-efficient manner. Last, for sellers of RIAs who have a high net worth, it may be advantageous to consider estate planning and gifting techniques to reduce estate taxes down the road."

Three professionals to consult

Hiring an advisor for the bidding and business terms, a lawyer who can examine the legal implications and a tax counsel to manage the payments to Uncle Sam can help sellers boost their gains and minimize their bills in the end, Furey said.

"The seller will always want long-term capital gains — that's always ideal, he said. "Most buyers in our space don't buy firms, they buy the assets of the seller, so it's an asset purchase almost always."

Assessing the options

RIAs and other small business owners accepting bids on the firm must decide between an asset sale or a stock sale, according to a guide to tax planning for M&A deals by Janice Angell and Stephen Baxley of wealth, investment management and family office firm Bessemer Trust.

The potential strategies for a stock sale include the qualified small business stock exemption, a tax-free reorganization, an employee stock ownership plan and a charitable gift prior to the deal.

For asset sales, sellers should consider the allocations in each component of the price, a possible 1031 like-kind exchange transaction, a philanthropic donation after the transaction and the impact of any net investment income tax, the report said. Other questions concern whether the deal will be structured as an installment sale, a seller's total tax outlook outside of the business and the rules for the home state of the business changing hands.

"For owners who have poured everything into growing their business, a sale may offer a sizable reward and the opportunity to create a post-sale family legacy and pursue life's next adventures," Angell and Baxley wrote. "A major tax consideration when you sell your business is whether you should sell the assets of the business or your stock in the company. There are advantages and disadvantages in both options. Generally, buyers want to purchase assets, and sellers want to sell their stock. Because of this dichotomy, not only do we advise you to engage and consult with your attorneys and CPAs, but you should understand what the pros and cons are to each."

An overview of selling strategies

Small business sellers ought to closely mull their options around stock or asset sales, possible sales of a partnership interest in the firm, the classification of their firm as an S-corporation, C-corporation or another entity, whether to structure the deal as an installment sale, a potential employee stock ownership strategy or reinvesting the sale proceeds toward a "qualified opportunity zone," according to a U.S. Small Business Administration blog by attorney and entrepreneurial strategy expert Barbara Weltman.

"Many business owners find it difficult to walk away from their businesses," Weltman wrote. "They love the action and don't have personal plans for their time in retirement. They can consider negotiating a consulting agreement with the buyer. This gives the departing owner ongoing income and continuing tax breaks (such as claiming the qualified business income deduction, if eligible). A sale of a business is a highly complex matter from a legal and tax perspective. Don't proceed without expert advice."

Three strategic issues

The key issues for sellers boil down to the possible strategies in three key areas: "income tax mitigation" through a non-grantor trust, an "opportunity zone" investment, a charitable remainder unitrust or an "interest-charge domestic international sales corporation"; a choice of "rollover exclusion techniques" like a Section 1202 qualified small business stock sale, a Section 1045 rollover or an employee stock ownership plan; and "estate freezing and transfer techniques" such as annual gifts, an installment sale to "an intentionally defective grantor trust," a private annuity strategy, a grantor retained annuity trust, a charitable lead annuity trust or a recapitalization with a family-limited partnership, according to an overview by BNY Wealth Management.

"Thoughtful tax, trust and estate planning, as well as business succession strategies, provide the greatest opportunity to maximize legacy economic wealth for business owners," the company's guide said. "With an estimated $30 (trillion) to $65 trillion in financial and non-financial assets in North America expected to transfer from the hands of baby boomers to their heirs over the next 40 years, reducing the tax impact of wealth transfer remains an essential component of building personal wealth and preserving multigenerational longevity."

Asset sale structure

Wealth Partners Capital primarily purchases minority stakes in RIAs that use the financing to acquire the assets of smaller advisory firms that receive equity in the buyer as part of the deal, according to Lawler. The sellers' goodwill value represents the vast majority or all of the assets changing hands in most of the firm's deals, he said. The equity from the buyers incoming to the sellers in the transaction carries important tax considerations.

"If you have a transaction that's 50% cash, 50% equity, that can allow half the consideration, the equity piece, to be tax-deferred," Lawler said. "They have zero basis in the equity, and then they hold the equity until whenever they dispose of it, and that's when the gain is recognized."

Cash and equity mix

EP Wealth uses a "hub and spoke model" in its M&A deals, in which the firm enters a new market by acquiring a large RIA there before adding smaller teams over time, Toumajian said. The smaller deals — especially those with retiring RIA owners — usually have a larger share of cash in the transaction, while the bigger ones "tend to see a mix of both cash and equity consideration" in the acquisition agreement, he said.

One big reason buyers like asset purchases

The goodwill portion of the assets changing hands in an RIA deal enables the buyer to lock in tax savings on the amortization expenses for many years into the future, according to Furey. He used the example of a transaction allocation valuing an RIA's goodwill at $15 million.

"The buyer amortizes the purchase over 15 years, and they get a deduction off their taxes," Furey said. "If you look at their balance sheet, you'd see this huge goodwill asset on their balance sheet that they're amortizing over time. They expense it over 15 years at $1 million a year. You're amortizing a million dollars in your company. That's hundreds of thousands of dollars in tax savings."

Estate tax impact

Potential reversions to lower thresholds for estate taxes in 2026 may affect the taxes on some RIA deals, Gregor noted.

"We are seeing more advisors concerned about estate taxes in addition to income taxes," he said. "With the Tax Cuts and Jobs Act scheduled to sunset at the end of 2025, many more small businesses and entrepreneurs, including RIAs, are expected to be subject to estate taxes. Some advisors are leveraging trusts and gifting to family members to significantly reduce the estate taxes that will be due on their passing. Overall, when considering the sale of an RIA, it is important to consider the after-tax proceeds of the transaction, develop a plan to continue to grow the business in a tax-efficient manner and consider succession and estate planning to pass wealth to future generations."

Charitable gift strategy

A philanthropic gift of RIA stock to a donor-advised fund after a qualified appraisal but before the transaction could bring hundreds of thousands of dollars in tax savings above those from a post-deal donation, according to a blog by Matthew Crow, the CEO of business valuation and advisory firm Mercer Capital. The strategy provides for a potential charitable gift deduction and "minimized capital-gains exposure for the portion donated and sold by the charity rather than the family," Crow wrote.

"Tax considerations rarely are the primary driver of major gifts, but the sale of an RIA (or any closely held business) offers a unique opportunity to use the prospective proceeds from the transaction to maximize giving," he wrote. "While gifts of closely held stock can be complex, the benefits of the strategy and the impact it can have are too significant to ignore."

Focus on the allocation of asset purchases

Advisors selling their RIA will be looking closely at the allocations of any asset purchase, since the part of the deal relating to employment agreements will be taxed differently than the portion for the goodwill value of the firm, Lawler noted. The IRS recognizes seven "classes" of assets.

"Allocations to goodwill result in capital gains, which is preferred," Lawler said, pointing out that the employment-agreement assets get treated as ordinary income. "If I'm a seller, I want to know how much of the purchase price that the buyer intends to allocate to goodwill versus, for example, restrictive covenants, noncompetes, those types of things."

Doing the allocation dance

The terms of the allocation play out as "a little dance" between buyers and sellers about the classification of the assets in a deal, Furey said. The main issue revolves around the amount of consideration toward the goodwill and other assets such as the employment agreement or any equipment infrastructure owned by the selling RIA. The sellers try to raise the portion for the goodwill and reduce the amount for employment agreements, he noted.

"If the buyer gets that, then they essentially pay the proceeds of the deal as essentially ordinary income. You pay a lot more taxes that way if you're the seller," Furey said. "It's figuring out — in the deal itself — what gets allocated to what."

Equity asset advantages

Any equity units of a buyer that go to an RIA that has sold its goodwill assets come with tax advantages for the next 15 years over the partial annual recognition of the difference in value, Toumajian noted.

"The tax basis of the goodwill is zero. As a result, there's a built-in gain. That built-in gain is the difference between the fair market value and the tax basis of the goodwill that's contributed," Toumajian said. "That tax treatment can be viewed as a better result than the transaction being entirely taxable in the year of the sale."

Equity questions

RIA sellers need to find out the post-transaction ramifications of any equity they may be receiving from a buyer as part of a deal, Roth said.

"Equity can be the biggest wildcard component of the purchase price," he said. "Most buyers are private companies, which means that their stock is mostly or entirely illiquid. Sellers should want to avoid paying taxes on the receipt of illiquid equity and not have to pay until they can sell the stock. Sellers should be aware of how the type of purchase agreement they are signing impacts the form of equity consideration they are receiving and how it is treated for tax purposes."

Cautions about C-corps

For any deal, the "entity structure matters," Furey said, noting that most RIAs or independent advisory teams favor a limited liability company structure. C-corporations enable some companies to reduce taxes on their profits, but they can create problems for firms seeking to change to an LLC or an S-corporation for an asset purchase deal, he said.

"It's really, really difficult to do it," Furey said, pointing out the problems with taking assets out of a C-corporation in a transaction. "Once you do the restructure, you have to mark up the basis and tax is due. You have to have a strong conviction that if you start a C-corporation, you're going to stay one."

Other important factors about entity structure

Asset sales for RIAs that are LLCs "tend to be more straightforward" than in the case of S-corporations, which "is more involved than you would see in an LLC," Toumajian said. For questions about the different tax factors involved with either structure or whether to hold any incoming equity units individually or through their entity, RIAs should consult tax professionals.

"A lot of the consideration mix can be dependent on the ultimate holder of those units post-close after an acquisition," Toumajian said.

Imputed interest tax payments

Some transactions stretch out the tax payments for sellers by recognizing the capital gains over multiple years through a so-called installment sale, Lawler noted. While that reduces the immediate impact, sellers ought to keep in mind that the IRS "applicable federal rates" will add some other tax into the mix down the road, he said.

"The IRS will impute interest on the future payments," Lawler said. "The portion of the purchase price that's deemed to be imputed interest is taxed as ordinary income rather than capital gains."

How deals have evolved

When Furey started his company 10 years ago, most of the deals consisted of "earnouts" structured as compensation based on the retention and growth of the selling business, he noted. While selling RIAs today can negotiate so-called contingency payments to be capital gains, the earnouts add ordinary income exposure, Furey said. The fact that most deals are asset purchases these days reflects the influence of private equity firms and other "more professional" buyers crowding into the industry, he said.

"When a seller has more choices, the buyers have to compete," Furey said. "The market is way more informed. There are no more dumb buyers or dumb sellers anymore."

Seller tax mitigation

M&A deals come with many "planning opportunities that are available to mitigate taxes on the sale of any business," Gregor said.

"Allocating a portion of the proceeds to charitable trusts or qualified opportunity zones may allow the seller to mitigate some of the capital gains incurred from the sale," he said. "With respect to the transaction, depending on which state the seller is located in and how the selling entity is structured, there may be an opportunity to have a pass-through entity pay state-level taxes to allow a federal deduction for state taxes paid. Some sellers also wish to spread out payments over a number of years to reduce their income tax burden."

Tax angle in recruiting

In the bidding process for selling RIAs, potential buyers offering up to 40% or 50% of the value of a transaction in equity can stand out from the competition, Lawler said.

"Being able to issue the equity on a tax-deferred basis is very attractive," he said. "If all of that is tax-deferred I think that's a pretty strong motivating factor."

The tax benefits of growing together

EP Wealth tries to find sellers who "are committed to the long-term growth" of the company and ready to contribute to it through their own organic expansion over time, Toumajian said. They get tax advantages for the "additional upside consideration" over time as the equity in the buyer becomes ever more valuable than the zero-basis level of their former company's goodwill, he noted.

"By recognizing a portion of the built-in gains each year, the sellers are accelerating the basis in those units," Toumajian said. "Every year sellers are building up basis in those units. In the future, if there was a sale of that, to the extent that they have basis in those units, they don't pay tax on that portion."

Seeing the big picture

Sellers must examine a potential deal's purchase price, employment agreement implications and any contingency payments, among a host of other factors, Furey noted.

"You've got to look at your transaction holistically," he said. "Everyone rushes to the purchase price, but it's what you keep net of your taxes. That's what matters."